Annuities are not the only way

When they retire, most people use their pension fund to buy an income guaranteed for the rest of their life – called a lifetime annuity. Once the annuity has been bought it pays a guaranteed income for life – however long that is. But if circumstances change it cannot be altered. Lifetime annuities give certainty but at the price of inflexibility.

Although more people now shop around to find the best annuity, many do not realise that they do not have to buy a lifetime annuity at all. Contrary to what some financial advisers and politicians say, ‘compulsory annuitisation’ as they like to call it does not exist – even at 75.

Since April 2006 the law has allowed you to take money out of our pension pot to give yourself an income without buying a lifetime annuity. Once you reach 75 the rules become more restricted and the alternatives more expensive. But even then an annuity is not compulsory.

From age 55 to 74 you can take a yearly sum out of your pension fund up to about 120% of the amount you could get from a lifetime annuity. It is called an ‘unsecured pension’. The amount you can draw is fixed and reviewed every five years. You can choose to take nothing. That can be sensible if you need to take your tax-free lump sum of a quarter of the fund – perhaps to pay off a debt or a mortgage. The rest of the fund can then be left until you need to convert it into a pension.

When you reach 75 you must decide again whether to buy a normal annuity for the rest of your life or take what is called an ‘alternatively secured pension’. You can no longer choose to take nothing out of your fund. The yearly income you draw must be between about 65% and about 90% of the annuity you could buy.

The permitted amounts above and below 75 are fixed by a complex formula which uses the interest rate paid on Government bonds. The table below shows the amounts you can take in April 2010 when that rate was 4.5%. It also shows the best annuity on the market which you could buy at the same date.

Even at 75 the amount you can take out of your fund without buying an annuity is comparable to the best annuity you could buy. However, there is a real risk that if you take the maximum you will run out of money before you die. Only a lifetime annuity guarantees you an income for life. And if you have taken the maximum allowed from the age of 60 or 65 there may not be much left to buy a further annuity at the age of 75.

Unfortunately you cannot just invest your pension pot or put it in the bank and take the permitted amount out yourself. Your fund has to be in a recognised plan with a financial institution. Currently there are two sorts of plan that qualify from 55 to 74 and just one from 75 on.

Drawdown
The traditional – but expensive – alternative to a lifetime annuity is called ‘drawdown’. Your pension pot – or what is left after you have taken out your tax-free lump sum – stays invested. Unless you opt for a pure cash investment, there is always the chance that the value of fund will go down rather than up. And of course whether your plan manager makes you money or loses it for you their charges will be taken out – and they can be very hefty. Because of these risks, people with less than £100,000 pension fund to invest are normally not advised to consider drawdown. The average pension fund is barely a quarter of that.

Fixed term annuities
Recently another alternative to a lifetime annuity has been invented for people under 75. It is called a fixed term annuity. The principle is simple. Instead of committing yourself to buying a guaranteed income for life, you use your pension fund to buy a guaranteed income for a fixed period. That can be five or ten years or as long as the time to your 75^th birthday.

Fixed term annuities give you two guarantees. First your income is guaranteed for the fixed term of the annuity. Second, you will get a guaranteed amount returned to you at the end – and how much that will be is known from the start. If you are under 72 at the end you can then use the guaranteed sum to buy another fixed term annuity. If you are older you can then consider an annuity or, if you are happy with the risk and the costs, a drawdown plan.

When the initial fixed term ends your life expectancy will always be less and your health may well be worse. That means the annuity you can buy with your now reduced sum will be enhanced. And if you had a spouse or partner at the start but for whatever reason no longer do that will also boost the second annuity you buy. So fixed term annuities enable you to rethink your needs every few years. By contrast a lifetime annuity is fixed and takes no account of future changes in health or circumstances.

Living Time, which invented fixed term annuities, gave Saga this example of a 65-year-old man with a £100,000 fund. He takes an income of £6,830 (compared with £6,857 a year from the best lifetime annuity) and he will then get a guaranteed sum of £72,538 at age 75. That would buy an annuity of £6830 if he was still healthy. But if he had hypertension or heart disease that would be £8,700 a year or £11,447 if he had cancer. So his income is more for ten years and slightly more at 75 assuming annuity rates do not fall between now and then. And he can get a much higher annuity at 75 if his health has deteriorated as it does for many people in that decade.

You still have to decide if you want a flat amount or one that rises with inflation. And you can spend a little of your fund to protect the income of a spouse or partner should you die early. With a fixed term annuity you can also choose the amount of income it provides – within the rules laid down by the Revenue. So you can take from zero to 120% of the typical rate on an annuity as calculated by the HMRC formula. The more you take the less you will have as a guaranteed return when the fixed term comes to an end. But you choose that balance between income now and income later. If you take roughly the same as you would get from a lifetime annuity then the final guaranteed payment should be enough to buy you at least the same income again. And if your health has deteriorated or your circumstances changed you may well get more. But there is a risk. With fixed term annuities the guarantees are short term while your life may be very, very long. So the money may not last as long as you do. And if annuity rates fall by the time you take a new annuity – especially when you reach 75 – your income may be lower than if you had taken out a lifetime annuity at the start.

Guarantee
Living Time originally marketed fixed term annuities as underwritten by the world’s biggest insurance company, AIG. Then in 2008 AIG became one of the biggest victims of the financial chaos which swept the world. Despite that, plans taken out before – and those being taken out now – survived the firm’s collapse completely intact. The underwriting company is now called Alico and later this year that will be bought by another mega-insurer, MetLife. If any annuity is safe, these seem to be.

Financial advice
As with any major decision you should take independent financial advice before making decisions on your retirement income. Tell your advisor that you want to pay a fee and insist that any product you buy is quoted on a nil commission basis. The advisor may well charge you between £100 and £200 an hour. But that will almost always cost you less and give you the reassurance that the commission cannot bias the recommendation. If you want to consider drawdown be very clear about the annual charges and the risk involved. If you prefer a fixed term annuity only two firms offer them now, Living Time and LV=, though other are expected to launch their own versions soon. If your total pension funds come to £18,000 or less you can take the whole lot as a cash sum – a quarter tax-free and the rest taxed at your marginal rate.

e-mail Paul Lewis on paul@paullewis.co.uk